Was The Equity Premium An Artifact Of The Great Depression?

Felix Salmon has made a big splash with his argument that now is a good time to sell stocks because they’re volatile.  My first instinct is to say that this doesn’t much matter for people under the age of 50.  As long as you’re putting a consistent amount of money in your 401(k), over time, it won’t matter; you’ll get more growth than bonds, and even though the market moves around, what you lose on the swings you’ll make up on the roundabouts.  You’ll probably need to give more attention to when you should start shifting your portfolio towards bonds than you would in a less volatile market, but in the meantime, you’ll still enjoy the benefits of growth in the stock market.

That presumes, however, that there’s still a substantial equity premium–which is to say, that stock returns will, on average, substantially exceed the returns on debt.  That assumption is based on 100 years of evidence.  But just because something was true for 100 years, doesn’t mean it will be true forever.

In fact, stock prices have the odd characteristic of many financial assets:  if everyone thinks that something is true, then it’s no longer true.  Efficient markets types tell us to invest in indexes because you can’t beat the market–but if everyone invested in indices, the market wouldn’t be efficient, and you could.  Portfolio theorists tell us that investing in a broad portfolio of stocks will yield a substantial annual return in excess of the return on US treasuries–but if everyone believes that stocks aren’t really much riskier than bonds, then they’ll bid up the prices until there’s little excess yield.

And indeed, one way to look at the great 1982-2000 stock market boom is that it represented the erosion of the equity premium. And one way to explain that is demographic:  the stock market began to boom when the generations that had lived through the Great Depression as adults began to die off.

Before the twentieth century, stocks were in many ways an immature financial instrument; they should have carried a premium, because they were risky.  As the twentieth century wore on, they matured–thanks in part to the New Deal era reforms that toughened up on disclosure and market rules for buying and selling shares in public companies.  But the generation who lived through the Great Depression still thought of the stock market as speculative.  There was a personal, social, and political shift towards less direct forms of saving for the future, such as corporate and government pensions, and life insurance products.

Unfortunately, those aren’t actually risk free either; we saw, catastrophically, the risk inherent in private pensions in the 1970s, and are now discovering the same thing about public pensions in our generation.  So there was a global shift back towards the stock market as an appropriate vehicle for private investment.  Meanwhile, while individual stocks remained both risky and volatile, more and more people were turning to indexing and mutual funds, which smooths out those variations.  People who might have demanded an equity premium for holding an individual stock didn’t need such a big one   As people stopped thinking of equity as the “speculative” investment, the equity premium may have been eaten away.

And of course, ironically, if the equity premium diminishes, in the short term, that means that the price of stocks jumps–making them look like an even better, and less risky, investment.

Or at least, that’s one plausible reading of this chart:  there’s a bubble, there’s a correction, but because the correction isn’t accompanied by a banking crisis the way it was in 1929, there’s no huge overcorrection where everyone gets shut of stocks for a few decades.  So what you get is a market where expected future growth is fully priced in, and there’s no substantial premium for holding equity over debt.  So all that’s left is volatility–stocks bouncing around in a mostly uncorrelated fashion that evens out over time, marked by a few unhappy moments when there’s some major market event and everything heads in the same direction at the same time.

If the equity premium is substantially diminished, or even gone entirely, then there’s no reason to favour stocks as much as most people do, other than as a way to hedge the inflation risk of your bond investments.  If that’s true, then it really might be time to sell.

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